Fixed Rate Loan Commitments, Take-Down Risk, and the Dynamics of Hedging with Futures

Abstract

This paper develops a normative model to analyze the hedging and fee-pricing decisions of a financial institution supplying fixed rate loan commitments to its customers. In supplying fixed rate loan commitments, the financial institution (hereafter referred to as “bank”) is assumed to act as an agent that transforms commitment risk through the use of financial futures contracts. While most previous loan commitment models have analyzed the interest rate (or price) risk the bank faces in supplying fixed rate loan commitments, they either have ignored or assumed away the loan take-down (or quantity) risk.